Are Countrywide Financial Bonds Bankruptcy Remote?

"The 900 pound gorilla in the room still is counterparty risk in all the OTC derivatives. Most contracts don't have standardized terms. No one knows who holds many contracts. If present holders of credit default swaps ("CDS") either fold or deny payment by trying to litigate over terms or try to settle claiming they were defrauded, then one side of the riskless arbitrage becomes risky and will need to be marked to market. The damage from prospective CDS defaults and deteriorating credit generally could make the housing debacle look like a warm up. Many corporate credit professionals don't understand this nor are they prepared to absorb the resulting losses and accounting restatements. Corporate bad debt allowances look as seriously underfunded as bank loan loss reserves, and will need to be increased substantially even as profit margins are declining - a double whammy for forward earnings." (Jerry Flum, CEO, Credit Risk Monitor)

The announced acquisition of Countrywide Financial
(NYSE:CFC) by Bank of America (NYSE:BAC) was in doubt on Friday because
of reports that BAC may back away from the deal. Pity CFC shareholders,
who are selling at something like 5% of book value (and this for BAC
paper), but we wonder how many of the CFC bond holders understand that
they may face an equal or greater haircut.

The CFC 6.25%s of
2016 closed at 79.125 on Friday or over a 10% YTM. The pricing reflects
the expectation that BAC will assume responsibility for the CFC debt at par. But
after hearing from some bankers in the know and reading the "Agreement and Plan of Merger"
filed with the SEC by BAC last week, we think that CFC bond holders
will soon get the joke.

Usually, when a company acquires another, the former assumes
the debt of the latter and agrees to make timely payments of interest
and principal as previously contracted. In the case of BAC's purchase
of CFC, however, BAC seems to view the transaction as an option.

Bankers who've been
briefed by BAC officials tell The IRA
that CEO Ken Lewis intends to keep the crippled thrift holding company
"bankruptcy remote" by merging CFC with a new vehicle, called Red Oak
Merger Corp in the merger plan, and that BAC does not intend to
consolidate the entity or take full responsibility for the CFC debt.

According to the plan: "…at the Effective Time, [CFC] shall
merge with and into Merger Sub. Merger Sub shall be the Surviving Company in the
Merger and shall continue its existence as a limited liability company under the
laws of the State of Delaware." (BAC public affairs officials Kevin Stitt and
Pamela Black did not respond to written questions sent by The
IRA
via email on Thursday.)

The implication is that BAC eventually will take
direct ownership of the FDIC insured Countrywide Bank FSB, which now has assets
of some $130 billion, leaving the remaining assets of the formerly public CFC
and a good chunk of its $105 billion in parent level debt at risk of an eventual
default. BAC officials are reported to have said that BAC's deposit
base and debt issuing power offer significant funding advantages to
CFC, but also said that BAC will keep the target separate for an
"interim period" of indeterminate duration.

FDIC
insured banks, you see, cannot file bankruptcy. Were BAC to even
contemplate putting the company formerly known as CFC into Chapter 11,
it would first need to move Countrywide Bank FSB to a different part of
the BAC group. Otherwise, when BAC was about to file the Chapter 11
petition, the Office of Thrift Supervision would intervene and invoke
its statutory authority as the bank's primary regulator to appoint the
FDIC as receiver of the bank, potentially stripping BAC of its entire
equity investment.

Readers of The IRA will recall our fascination
with the televised interview between the money honey, Maria Bartiromo, and CFC
co-founder and honcho Angelo Mozillo, the bronze god of affordable
housing. Last September, we described ("When Flying to Quality, Be 'In the Bank'", September
10, 2007)
why the phrase "in the bank" was so significant to investors holding
CFC debt and equity.

According to statements allegedly made by BAC officials during
private conference calls held over the past two weeks, statements which
are nowhere to be found in BAC's public disclosure filed with the SEC,
the CFC debt is expected to be "assumed not guaranteed," this under the
theory that "the biggest risk at CFC was liquidity and that when the
deal closes, that risk goes away," according to a banker involved in
the conversations.

The BAC strategy is reportedly to manage the orderly
liquidation of CFC, excluding Countrywide Bank FSB, and to guarantee
payments of interest and principal so long as the remaining non-bank
assets and liabilities of CFC support same. The BAC officials
reportedly expressed the view that keeping CFC is a separate subsidiary
of BAC insulates the rest of the group from legal liabilities and
"arguably prevents them from ballooning out of control," says the
banker.

If BAC officials are keeping CFC "bankruptcy remote" to
protect the large organization from legal and financial losses from the
ex-bank portion of CFC, which includes the bank's conduit and non-bank
assets, the implications for CFC debt holders - and holders of bank
debt generally - are quite grim. If the same fire sale valuations seen
in the market for subprime assets are applied to the ex-bank assets of
CFC, then the Friday close of 79 cents per dollar of face value of CFC
bonds may be a tad on the high side.

More to the point, if the Fed, OCC and OTS are willing to
countenance a bank merger transaction where BAC does not explicitly
stand behind the parent company debt of CFC, what does this say about
the debt of other relatively small bank holding entities such as
Washington Mutual (NYSE:WM) and Capital One (NYSE:COF)?

If CFC is to be allowed by regulators to fall into bankruptcy
once the insured bank subsidiary is secured, then how about WM and COF?
Are the Fed and other regulators indifferent to the systemic
implications of such a transaction? More important, don't investors in
BAC and CFC securities have a right to an unambiguous statement from
BAC CEO Ken Lewis regarding his intentions with respect to CFC debt?

Unfortunately we cannot participate in the BAC conference
call today due to a previously scheduled client meeting, but perhaps one of
our colleagues in the analyst rat pack will ask BAC to elaborate on the
following:

1) Were the statements we describe regarding the acquisition
of CFC, in fact, made by officials of BAC?; and

2) If so, why were these statements not immediately made
available to all BAC and CFC investors?